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2 Pair Trades for a Market Ready to Bounce - 8515 views
MINNEAPOLIS (Stockpickr) -- The general idea behind the absolute return approach of pair trades is to manage risk -- not to generate monster gains. But that doesn't mean big gains are out of the question.
Case in point is my most recent pair trade, which included a short of much-maligned Research In Motion (RIMM). Two days after my recommendation, Research In Motion released guidance that widely missed Wall Street expectations. Already depressed, shares fell approximately 20% in trading the day after the news.
Who says managing risk has to be boring?
The nice thing about pair trades is that with a market moving in different directions, there are always opportunities to find stocks to buy long paired against stocks to sell short. Recently we've seen oil prices swing wildly. With the volatility, stocks in the oil group present an interesting pair trade opportunity.
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In addition, last week’s earnings beat from FedEx (FDX) portends well for the market in advance of second-quarter earnings season. The stock market is solidly in negative territory over the last few months. Investors are anxious about the economy and worried about reduced profit expectations going forward. FedEx noted that the economy had indeed experienced a soft patch in the second quarter, but the company was able to beat expectations. More important, guidance going forward was strong and showed no sign of possible deleterious effects of inflation and weak economy.
With markets bouncing along technical lows, conditions are ripe for a bounce. A pair trade will help offset potential losses in the off chance that earnings miss expectations. Shorting a weaker player in a pair trade is a great way to reduce risk while still capturing any upside move in stocks.
Here are two pair trades to consider.
Long Chevron/Short Tesoro Petroleum
Oil traders got a cold shower last week with the announcement by the Obama administration that it along with other governments planned to dump 60 million barrels of crude on the market. That news had the intended effect of pushing oil prices down some $4 per barrel.
If FedEx management is correct in its assumption about global growth, demand for oil is likely to increase. Given that supplies, other than the temporary effort of governments trying to flood the market with oil, are weak, oil prices will quickly recover.
Within the oil complex, there are stocks to buy and stocks to sell. On the long side, I like Chevron (CVX). Shares are down 7% since the end of April even though oil prices are still at fairly high levels. The fear is that the economy is slowing and that as a result demand for crude will be less. The selling surely has little to do with valuation.
The average Wall Street estimate for profits in the current fiscal year is $12.94. At current prices, Chevron trades for 7.5 times current-year earnings. In addition, the company pays a big chunk of that profit in the form of a dividend. The dividend yield on the stock is a very healthy 3.1%.
At a minimum, investors are unlikely to get hurt with Chevron. With so much market uncertainty, holding Chevron in a pair trade is a great way to generate absolute returns. Where you just might make some decent money is by shorting the oil refiner Tesoro (TSO).
Oil refining is a tough business. Margins are very thin, so any volatility in pricing can create havoc with profits. That said, over the last year prices have been moving in one direction: higher. That stability helped Tesoro to an 83% increase in stock value over the last year as stability succumbs to uncertainty.
The tug of war between OPEC, oil traders and government manipulation volatility is likely to increase. Already Wall Street has an uncertain view on Tesoro. The average Wall Street estimate for profits is expected to fall between the current fiscal year and the following year. Shares are not horribly expensive, but the likelihood of gains is low.
The higher probability is that Tesoro shares decline from here making it a good short in a pair trade.
Long Delta Airlines/Short United Airlines
Airline stocks were lower on Friday thanks to less-than-stellar revenue forecast from United Continental (UAL). Shares of United were down 8% after the company stated that June revenue would be 3% to 4% higher year over year. That number was less than expected by Wall Street analysts and was greatly lower than the 14% to 15% jump the airline had seen in May.
The reduction in revenue makes sense given a softening of oil prices during the month. Fuel surcharges were apparently rolled back. At the same time, the soft patch in the economy resulted in greater discounting with fares. According to one analyst at UBS, the news suggests that profits in the period are likely to miss current Wall Street estimates.
I’m not so sure about that conclusion. If June was especially weak, I would argue that simply offsets a strong May. Net, net the news is a wash. More important for the market will be future guidance and if FedEx’s earnings are any indication, guidance should be better than expected.
Stocks in the airline sector are already depressed. The recent selling only makes the sector more attractive. From a pair trading standpoint investors can hedge their bets with a long and a short. Don’t look for home runs here, but incremental gains should be attainable.
On the long side, I like Delta Airlines (DAL). Its stock was only down 5% on Friday, relatively better than United’s performance. The selling of Delta has the stock approaching 52-week lows. Just prior to the company's reporting results in April for the first quarter, shares were only slightly lower, at approximately $9 per share. After Delta released results that were better than expected, shares jumped 20% in a few short trading days.
Could we be in store for a repeat performance? United’s news is troubling, but with the stock already near yearly lows, there appears to be limited downside for Delta.
On the flip side of this trade, would be a short of United. Although the stock sold off hard on Friday, I’m a bit more worried about how United will fare when it releases earnings. One possible reason for the poor revenue numbers in June could be various service disruptions. The airline had a computer glitch during the month that grounded many flights. In addition poor spring weather had a similar impact.
The same, other than the computer issue, could be said about Delta, but with a pair trade we are looking for relative differences. The computer problem may be just enough to result in United shares lagging behind Delta, exactly what you want in a pair trade.
I would go long Delta and short United.
Delta, one of TheStreet Ratings' top-rated airline industry stocks, is one of the top holdings of Ken Heebner's Capital Growth Management. United shows up on a recent list of the Top Stocks of the 10 Best Mutual Funds and is one of David Tepper's top holdings at Appaloosa Management.
To see these stocks in action, check out the 2 Pair Trades for a Market Bounce portfolio.
-- Written by Jamie Dlugosch in Minneapolis.
At the time of publication, author had no positions in stocks mentioned.
Jamie Dlugosch is a founder and contributor to MainStreet Investor and MainStreet Accredited Investor. Formerly, he was president and CEO of Al Frank Asset Management. He has contributed editorially to The Rational Investor, The Prudent Speculator, Penny Stock Winners and InvestorPlace Media.